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Not Quite a Stock… Not Quite a Bond

Stock prices are expensive by just about any traditional metric you want to use (and have been for years), yet prices keep edging higher. And it’s doing this in the face of Fed rate hikes and rising long-term bond yields.

It reminds me a little of the late 1990s. Fed Chairman Alan Greenspan warned of “irrational exuberance” in the stock market in late 1996… yet prices continued to get even more irrationally exuberant for another three full years.

Is history repeating itself?

Frankly, we can’t really know that until after the fact. All we can do is look at the options we’re given, and follow the value.

This brings me to just one pocket of the private income fund market that is poised to do well if the market continues to push higher… but not get hurt too badly should the market finally succumb to its high valuations and roll over: convertible bonds.

For the uninitiated, convertibles are bonds that can be converted into company stock at a fixed price, generally well above the current stock price.

Companies issue convertibles over traditional debt or equity for a couple reasons. To start, stock holders tend to get angry (and justifiably so) when a company issues new stock, as this dilutes the existing shareholders and usually pushes the share price lower.

If a company announces that it plans to increase its shares outstanding by, say, 10%, the share price will generally fall by a comparable amount. So, by issuing a convertible, the company is guaranteeing that any share dilution will happen in the future and at a higher price.

Investors should find that a lot less irksome.

Convertible debt also tends to trade at a lower yield, as investors are willing to accept lower current income for the potential future payoff of stock conversion. This keeps the company’s cost of capital down.

For investors, the benefits are obvious.

You get the upside of long-term stock ownership but without the risk. If the stock price soars, great! You convert your bonds to stock and enjoy the profits. But if the stock languishes, you still enjoy the current income stream from the bonds and the peace of mind of knowing that the bond will eventually mature at par value, returning your principal to you.

And should the worst happen – bankruptcy – as a bondholder, you get made whole before the stockholders recover a single red cent.

So, convertibles are a nice hybrid asset class with most of the best attributes of both stocks and bonds.

Alas, it’s not all sunshine and roses. There are a few issues that I have to address.

To start, the companies that issue convertibles tend to be a little on the riskier side. The lower interest payments are particularly valuable to younger, riskier companies in need of growth capital. By buying a fund, you massively lower the risk that a default will torpedo your portfolio, and that makes me comfortable with the asset class. But let’s be clear that we’re not buying AAA-rated Johnson & Johnson bonds here.

The second issue is that of liquidity. Lack of liquidity is a problem throughout the bond market these days, even in the Treasury and muni bond space. (It’s partially an unintended side effect of the Dodd-Frank regulations; due to the restrictions on trading their own accounts, banks have massively cut back their bond trading desks.)

The bonds of smaller companies tend to be even less liquid. Again, by owning these in a fund – and particularly a closed-end fund – this risk is mostly mitigated. Unlike a traditional mutual fund, these types of funds can’t be forced to sell their bonds due to shareholder redemptions. They can generally ride out any minor rough patches.

Convertibles are attractive right now for a couple reasons. To start, they give you equity upside if, as Harry expects, the stock market goes higher over the next several months, or more. But they also have less downside than owning stock funds outright, and they are a nice portfolio diversifier.

I’ve recently recommended a convertible bond fund trading at a deep discount to net asset value… and yielding a fat 9%. So even if the market goes sideways for months, we’re likely to chalk up a respectable return. And if the market continues to push higher, returns of 20% or more over the next year are very possible.

Next week, I’ll reveal much more important and potentially ultra-lucrative income secrets; ones that’ll hand you automatic income every month. Watch this space for more information.